The Highest Possible Returns. Period.

In 1992, I was 26 and already spending my fair share of time online. For several years, I'd been a satisfied customer of America Online. Although I liked the service, I decided not to buy shares of the company at the initial public offering that year. I thought I'd wait awhile. (Idiot.)

I kicked myself for two years while the stock quadrupled. In the spring of '94, I followed my instincts and became an AOL shareholder -- in spite of an article in a major financial publication that declared AOL grossly overvalued and predicted that the stock would decline by 35%.

The following year, the stock dropped 25% or more three times. And then in 1996, shares absorbed a drop of 65%! Despite these setbacks, the company went on to wreak havoc on both the business and journalistic establishments en route to putting up some of the best returns available during a decade of great investment returns.

Even with all the temporary downturns, and even though the stock is today down from its all-time high, my initial investment has still increased about 24 times overall -- which amounts to an annualized return of more than 24%.

We'd all love to find the next AOL or Amazon.com or whatever. That goes without saying.

But how can ordinary investors like you and me -- a couple of regular Fools -- find the next great company? It's not impossible. If you can train your eyes to spot innovative companies breaking the rules in their industries, you increase your odds dramatically.

You can't score if you don't shoot
The Wise of Wall Street would chalk up AOL's 24% annualized gains to luck. "No one can really identify the great companies of the next generation," they'd say. Growth stocks are too risky; it's best to avoid that style of investing altogether and let a Street "expert" manage your investments.

I disagree. Investing in great companies early in their high-growth stages and then holding them for the long term will provide the highest possible returns. Period.

We call those companies Rule Breakers. Our investment service of the same name seeks out the great growth stocks of tomorrow -- the potential AOLs -- before the Street catches on.

Think big, but keep an eye on the basics
Boiled down, I look for six signs of a potential Rule Breaker:

  • Sign No. 1: Top dog and first mover in an important, emerging industry.
    Top dogs are active, fast-moving market leaders. In 1994, AOL was a top dog. Some years earlier, Microsoft was a top dog before making its impressive run. First movers seize a temporary edge over the competition and then exploit that advantage. These companies come from emerging industries -- for example, from biotechnology today or e-commerce a few years back -- because it's unlikely that the railroad or meat-packing industries have much room left to run.
    Rule Breakers are not hidden; they are right before our eyes, and they bring a disruptive technology, clever and effective marketing, or a brand-new business model to this little backwater planet of ours. They rattle our capitalistic foundations.
  • Sign No. 2: Sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors.
    Can the company protect the advantage it obtained from its first-mover status? By being the low-cost provider, Southwest Airlines (NYSE: LUV  ) has over the years been one of the world's most profitable airlines. That has helped it join AMR Corp. (NYSE: AMR  ) as one of the few airlines to avoid the bankruptcies that have plagued competitors such as UAL Corp. (NYSE: UAUA  ) and Delta (NYSE: DAL  ) .
  • Sign No. 3: Strong past price appreciation.
    This is the easiest one of all to identify. Every day, the Wall Street pooh-bahs declare that this or that stock is overvalued. Almost immediately after computer maker Dell began trading in 1988, the naysayers started predicting its doom, considering its competition among such well-established names as IBM and Hewlett-Packard. But although it's fallen on hard times of late, Dell revolutionized the way consumers buy and customize their computers and consequently forced IBM and Hewlett-Packard to react to the new standard.
  • Sign No. 4: Good management and smart backing.
    This is the most important attribute of all -- and it might be the most difficult to get right. Few would disagree that visionary leaders are behind the greatest companies of our generation: Apple (Nasdaq: AAPL  ) has Steve Jobs, Nike has Phil Knight, and Google has Sergey Brin and Larry Page. Investors should also be prepared to learn about the venture backers of a young company. If the very best venture capital firms are behind a company, maybe you should be, too.
  • Sign No. 5: Strong consumer appeal.
    Rule Breaking companies provide products or services that improve the quality of people's lives. For years, Nike dominated the world of athletic goods. But then along came Under Armour, which has taken personal athletic apparel to new levels of performance and consumer satisfaction.
  • Sign No. 6: You must find documented proof that it is overvalued according to the financial media.
    You see this all the time. Remember when Baidu (Nasdaq: BIDU  ) shares began trading publicly, and the naysayers called it "overvalued" and a "one-country wonder," and worried it couldn't stand up to Yahoo! (Nasdaq: YHOO  ) and Google? Even today, with the vast majority of stocks having taken huge hits, there are some companies with improving fundamentals that Wall Street is afraid to touch because they appear more expensive than others.
    If a company's growing earnings lead to an increasing valuation, someone somewhere will surely argue that the company is overvalued. The reason this is valuable is that it keeps people out of a stock. Later on, as the company proves out its position as a profitable, even dominant, leader, then the skeptics finally buy -- which is what can give you serious appreciation as an early investor in Rule Breaker stocks!

Before they were blue chips
So there you have it. Those are the characteristics I look for in tomorrow's landscape-changing companies.

It's essential to our strategy to identify great companies early in their growth cycles. Then we hold for the long term. Indeed, many of the best examples of Rule Breakers are today's blue-chip companies. You may recognize a few:

Company

Date*

Initial Investment

Current Value**

Return

Compound Annual Growth Rate

Apple

1986

$1,000

$45,259

4,526%

18%

Dell

1990

$1,000

$131,667

13,192%

29%

Microsoft

1988

$1,000

$70,417

7,042%

23%

*Two years after the company went public. **All prices adjusted for splits and dividends.

Each of these companies had the six signs of a Rule Breaker at one point in its growth cycle -- and each posted fantastic returns as a result. There are other not-as-famous companies out there -- hundreds of them -- that once were poised for the limelight but now are forgotten. In most cases, the flameouts and the fakers significantly lacked one or more of the signs we pointed to above.

There is no trade-off
With detailed information on more than 6,000 publicly traded companies, the stock market can't help being fairly efficient. But the market doesn't have all the information, does it? Many people insist on following the rules laid down by Wall Street or by the latest "this is the way to invest" fad investment book, regardless of how banal or unsuccessful these prescribed rules behave in practice.

There's our opportunity. My team of analysts at our Motley Fool Rule Breakers investment service searches obsessively for these opportunities. Each month, we give you two new Rule Breaking ideas that we believe are worth holding onto over the long run and will have superior returns to the market.

If you'd like to read our analysis of all our potential Rule Breakers in greater depth, join us for a free 30-day trial today. You can cancel your trial at any time -- you have my word. Click here to learn more.

And one last thing. As big-time Rule Breaker Steve Jobs told Stanford graduates: "Stay hungry. Stay Foolish."

This article was originally published on June 23, 2005. It has been updated.

Fool co-founder David Gardner owns shares of Amazon.com, Microsoft, Apple, Baidu, and AOL's parent company, Time Warner. Apple and Amazon.com are Stock Advisor recommendations. Dell and Microsoft are Inside Value selections. Google and Baidu are Rule Breakers picks. The Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 24, 2009, at 2:54 PM, HPRinvestor wrote:

    I really enjoyed your article, as it is in down to earth language and quite refreshing in content; kind of reminds me of Peter Lynch's two books, only without the technical data that most of us don't understand anyway. Please continue to help us investors to believe that yes we can find companies and hold them, especially when the so-called experts are talking down about our companies!

    There is one company that came to mind to me in reading your article, but it does not seem to fit all 6 signs that you listed, although I am buying as much as I can afford of this company after speaking with their scientist and seeing howing they really have made progress in multiple products/tests and now therapeutics for making our food supply (milk/beef), and for humanitarian reasons as they will not require even one animal, never mind an entire herd (as is currently done) to be killed for testing for

    Johne's, Crohns, E-Coli, Mad Cow, and I forget the name of the brain wasting disease that affects midwestern elk and deer. Their website is genethera.net and I cannot believe that every dairy, beef, and now bison farmer, not to mention every parent is not helping this company to get their food safety tests to market, especially after reading how even pasturization(sp) is not proven to remove some of these diseases and who has not worried about eating beef with E-Coli. Anyway, even though I invest in much larger cap companies, this one came to mind as a high possible return stock. Best Regards and Thank you very Much!

  • Report this Comment On September 24, 2009, at 6:02 PM, HPRinvestor wrote:

    I apologize for my delay in explaining my comment about my belief in the biotechnology company Genethera being a potentially very high potential return stock.

    Sign number 1:

    "We believe this compound will provide us with a distinct competitive advantage, as to our knowledge no comparable type of therapy exists or is being tested."

    Sign number 2: The compound, called LIPOSTIM, will be tested as a possible therapy against veterinary mycobacterial disorders such as Johne's disease, an infectious, fatal and as yet incurable bacterial ailment that affects the intestinal tract in livestock and may be linked to Irritable Bowel Syndrome (IBS) and Crohn's disease in humans.

    Sign number 3: $11.50 down to $.082 with less than 17 Million share outstanding http://finance.yahoo.com/q?s=GTHR.PK

    Sign number 4: Genethera Doctors have earned degrees at U.S. and European universities, in addition to research and being professor at universities in CA/TX/GA/CO, etc...http://www.ir-site.com/genethera/directors.asp

    And latest press release indicates that backing is by funding arm of NJ-based Pharma Finance Conference

    http://finance.yahoo.com/news/GeneThera-Finalizes-License-iw...

    Sign number 5: improving food safety by applying the latest molecular technologies to eradicate farm animal disease. The company focuses on developing molecular diagnostic testing and vaccines in the belief that better technology use leads to a better life for all of mankind.

    http://www.ir-site.com/genethera/default.asp

    For sign number 6: All I could find is that in a SEC Filing they list competitors in this idustry of Idexx and Bio-Rad, so based on that I felt that they are extremely undervalued; and do not appear to meet the criteria of sign number 6...I hope this helps and look forward to seeing others comment about the above article and share their thoughts on investments!

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